Saturday, 28 February 2015

I do not remember much from my university days, but I remember
one meeting where the subject was student finance. This was a time of student
grants rather than loans, and the proposal being debated was to replace grants
with some kind of loan or tax. Speaker after speaker went through how student
grants amounted to a payment from those not attending university to those that
did, while those that did benefited from the return on the ‘human capital’ a
university education gave them. The logic on equity grounds for switching to
loans seemed compelling. Then someone stood up, and talked of his background
from a mining family in Wales, how he was the first of his family ever to go to
university, and how this would never have happened if they had not had access to
a grant. Those arguing for loans fell silent, and their proposal was lost.

Can the same logic be applied to Ed Miliband’s proposal to reduce the
maximum tuition fee from £9,000 to £6,000? It is a very different starting point, as most UK
students now pay this fee from a loan rather than a grant, but the
distributional consequences are essentially the same. In the UK graduates only
have to start repaying their loans once their income exceeds a threshold, and
many will not pay some or all of it back as a result. Reducing the loan
therefore mainly benefits those students towards the top of the income
distribution. Labour’s proposal has mitigated that effect slightly by
increasing the interest rate that high earners pay, but the IFS say
that “mid-to-high-income graduates are the primary beneficiaries of this
reform, with the very highest earners benefiting the most, despite the rise in
interest rates that they would face.” The fact that the policy is being funded
by cuts in pension relief which will hit similar groups is not really relevant,
because that money could have been used for something else.

So why are Labour proposing to increase inequality in this way?
Is it because they hope that lower fees will encourage those from poor
backgrounds to go to university? One of the remarkable features of the
Coalition’s decision to increase fees is that it does not seem to have reduced
the numbers becoming full time students coming from such backgrounds, although the numbers are still very low. Of course we
cannot be certain what might have happened to these numbers without the fee
increase. It is also important to note that applications for part-time enrolment
have fallen back as a result of higher fees.

However I doubt very much if encouraging the poor to go to
university is what lies behind this policy announcement. Labour are slowly but
steadily losing this election. Every time I look at the predictions for the
number of seats, it seems as if Labour has dropped one or two at the expense of
the Conservatives. Putting luck to one side, there seem no obvious events
between now and May that will change this trend, while George Osborne has a
budget that will be sure to include plenty of pre-election
bribes to carefully selected groups, to add to the many already announced.

Perhaps Labour’s only hope is that they can galvanise those who
traditionally do not vote: the young. The old are much more likely to vote than
the young. In 2010 just over 50% of the 18-24 age group voted, but nearly 75%
of those 65 or over voted. And the young vote left.

The chart below shows the ‘age gap’ by party, where the age gap
is the percentage of the 18-24 age group who voted for a party, less the same
percentage for the 65+ age group. The data for ‘now’ is taken from this Populus poll (Table 3). The age gap for
the Conservatives has been steadily increasing over time. The LibDems benefited
hugely from young voters in 2005 and 2010, but perhaps partly as a result of their change in policy on
tuition fees that gap has completely disappeared. The youth vote has gone back
to Labour as never before, but it is vulnerable on two counts. First there are
the Greens. In this Populus poll 16% of the 18-24 group said they would vote
Green (compared to just 2% of the 65+ group), but in this YouGov poll they were on level pegging
with Labour. This volatility suggests there is all to play for. (Only 5% of the 18-24 group intended to vote for UKIP, compared to 17% for the over 65s.) Second, there
is the question of how much this group will vote.

UK voting age gap between young and old. Source (actual elections): IPSOS Mori

Labour therefore need to galvanise the youth vote, and to do
this it needs a cause. The collapse in the LibDem vote among the young suggests
tuition fees could be a potent force, whatever the actual distributional
consequences of the policy are. This against a background where young people
are finding it more and more difficult to buy a house, and the distribution of
income and wealth is moving in favour of the old. This is an
election more than ever before about a clash of interests between the old and
the young. The Conservatives have already given their fair quota of bribes to the old, so it really
was a no brainer that Labour would do the same to the group that could just
save this election for them.

Friday, 27 February 2015

After the collapse of output of some 6-7% engendered by the
financial crisis, output per capita grew by “just under 2%” from 2010 to 2013,
whereas in 1981-84 and 1992-95 growth was over 8%. Wren-Lewis comments: “In
short, the performance of the coalition government has been a disaster.”
“Disaster” is a strong word from such a rigorous academic as Wren-Lewis, but I
fully agree with him.

I like the idea - which is probably true - that rigorous
academics generally refrain from calling things a disaster in print. Does that
mean I’m not as rigorous as Keegan believes? I thought I’d try and justify my
departure from this norm with some more data. It comes from a newly released dataset put together by the Bank of England.
I’ve used it to calculate GDP per head over a much longer time horizon than
I’ve shown before. Here it is.

It is a story of two trends: one from 1820 to WWI, and another
from the end of WWII until the financial crisis. Now whether this really is a
good way to describe how the economy evolved over the last two centuries I will
leave to others, but it is remarkable how well this simple idea of deviations
around a constant trend seems to work for the UK economy. To see this more
clearly, here is 1820 to 1913 with the trend drawn in.

The trend growth rate is just under 0.9% per annum. Here is the
equivalent graph since 1950.

The trend growth rate, estimated from 1950 to 2010, is more
than double that of the 1800s, at about 2.25%. Quite when and why the growth
rate increased so much between the two world wars is a huge question, but my
concern here is with deviations from these trends. Apart perhaps from two booms
- the 1870s and the 1970s - large deviations from trend are short lived, with
correction back towards the trend occurring pretty quickly.

The big exception, of course, is what has happened since the
Great Recession. The deviation from trend just kept on getting bigger, and even
with a fairly generous estimate for 2014 the best that can be said is that we
might have started growing at trend again, so the gap has stopped getting any
bigger. Even after the slump of 1919-21, GDP growth for the next four years was
well above trend. What has happened since the financial crisis is
unprecedented. This below average growth in GDP per head is one reason why real
wages have been falling steadily over this period, which is also unprecedented.

It could of course be that what we are seeing is part of an
adjustment to a new lower trend growth rate that was going on behind the scenes
before 2010. That is what the methods used by the OECD and IMF (but not the
OBR) assume. However they imply that 2007 was a huge boom in the UK, whereas
all the other evidence says any boom was decidedly
modest. It could be that these trends can suddenly shift after traumatic
events. What is abundantly clear is that the last few years are no success
story, and the constant drum beat in macromedia that the economy is doing well
is completely inappropriate. A much better way of describing the last four
years is to say it has been a disaster.

Thursday, 26 February 2015

Helicopter money started as an abstract thought experiment:
money would be created and just distributed to individuals by helicopter. If we
think of a consolidated government which includes its central bank, then it is
clear that in technical terms this is a combination of monetary policy (the
creation of money) and fiscal policy (the government giving individuals money).
Economists call such combinations a money financed fiscal stimulus. With the
advent of Quantitative Easing (QE), it has also been called
QE for the people.

Some have tried to suggest that central banks could undertake
helicopter money for the first time without the involvement of governments.
This is a fantasy that those who dislike the idea of government have concocted.
Others who dislike the idea of fiscal policy have suggested that helicopter
money is not really a fiscal transfer. That is also nonsense.

Helicopter money is a particular form of money financed fiscal
stimulus. It has two key features among the class of all possible money
financed fiscal measures. The first is that it involves a particular kind of
fiscal policy. A helicopter would distribute this fiscal transfer randomly, but
what most people have in mind is an equal distribution to every person (adult?)
- a kind of reverse poll
tax, or what economists would call a lump sum transfer. The second is that,
once the apparatus for helicopter money had been established by the government,
its use would be initiated by the central bank, whereas other fiscal transfers
are initiated by the government.

I want to suggest that it is this second aspect that is
critical. You could imagine the government making a transfer to every person,
and you could also imagine the central bank distributing money to only those
people who paid income tax the previous year. The fact that helicopter money is
initiated by the central bank seems more like a defining characteristic. If
helicopter money could be ordered by the government, we would say that the
central bank was no longer independent.

This defining feature of helicopter money is also what makes it
attractive from the point of view of macroeconomic stabilisation. It removes
the Achilles’ heel of the consensus assignment. The consensus assignment
allocates demand stabilisation entirely to monetary policy run by independent
central banks, while fiscal policy’s role at the aggregate level is to focus on
deficits and debt. The Achilles’ heel is that interest rates can no longer be used
to control demand when they hit their lower bound. QE tries to fill that gap,
but helicopter money would be much more reliable and effective. Of course
governments could make the transfers themselves through deficit finance [1],
but the evidence of the last few years is overwhelmingly that they become
fixated with reducing deficits in a deep recession with the result that we get
fiscal contraction rather than stimulus.

This last point raises a potential problem with helicopter
money, which is that government may take the opportunity to offset its impact
by raising taxes or reducing transfers, and we end up simply monetising part of
government debt. One would hope that does not happen for three related reasons:
first, governments are rather less agile than central banks, second, good
governments should be working with fiscal rules that specify a medium term plan
for deficits, and third the monetary stimulus is only temporary, so there would
be little long term benefit in terms of deficit reduction if governments tried
to play this game. [2]

If initiation by the central bank is the defining feature of
helicopter money, and this policy always requires the cooperation of
government, might it be possible to imagine a form of helicopter money that was
more ‘democratic’? Why could the central bank not give the government the
money, on condition that it was used
to increase transfers or reduce taxes in some way? A left wing government might
decide that, rather than giving money to everyone including the rich, it would
be better to increase transfers to the poor. A right wing government might
decide it should only go to ‘hard working families’, and turn it into a tax
break. We could call this democratic helicopter money.

I can see two problems with democratic helicopter money.
Suppose the government decided to use the money for a tax break that went to
people with a very low marginal propensity to consume. If the central bank
fixes the scale of the monetary stimulus beforehand, it makes that stimulus
much less effective. If it increases the size of the stimulus following the
government’s decision on how to spend it, this gives perverse incentives to
government: think of inefficient ways to stimulate the economy, and we will
give you more money.

One way to reduce such problems is for the central bank and
government to cooperate over the size and form of any money financed fiscal
stimulus. This could have added benefits. Most studies,
and theory, suggest that the most effective fiscal stimulus tool is to bring
forward public investment projects. With democratic helicopter money, the
central bank and government could cooperate on this policy, rather than or as
well as implementing a tax cut or transfer. However such cooperation creates a
second potential problem, which is that it puts at risk the perception (and
perhaps the reality) that the central bank was both independent and
non-political.

Given these problems, why even think about democratic
helicopter money? One reason may be political. A long time ago I proposed
giving the central bank limited powers to make temporary changes to a small set
of predefined tax rates, and I found myself defending that idea in front of the
UK’s Treasury Select Committee. To say that the MPs were none too keen on my
idea would be an understatement. Making helicopter money democratic may be what
has to happen to get politicians to support the idea.

[1] Combined with QE, this could become a money financed fiscal
stimulus. An alternative way of avoiding this deficit fixation is to get
governments to adopt a fiscal rule where, when interest rates were likely to
hit the lower bound, the central bank in cooperation with the fiscal council
proposes increasing the deficit by adopting a fiscal stimulus package of a
particular size. This is the proposal in Portes and Wren-Lewis (2014). If instead the
stimulus package was money financed, it becomes helicopter money.

[2] None of these considerations, even collectively, rule out
the possibility that governments could negate helicopter money in this way.
This point and the previous footnote show that all we are really talking about
here is the effectiveness of different institutional mechanisms of persuading governments to
allow fiscal stimulus in a recession, and to avoid the adoption of austerity.

Tuesday, 24 February 2015

In my simple guide to the current macroeconomic
position of Greece, I said that a major mistake made by the Troika was to
insist on a pace of fiscal adjustment that was far too fast. It led to a
collapse in the economy. Of course a collapse in the economy itself raises the deficit.
So people who just look at the deficit, including many comments on that post,
say ‘what adjustment’ and ‘just how many years does Greece need’.

It is easy to avoid this trap. The OECD publishes a series for
the underlying primary balance, which is their guess at what the primary
balance (taxes less spending excl. interest payments) would be if the output
gap was zero. It is the first row in the table below: the estimated output gap
is below. I’ve also shown the scale of the decline in GDP, just to show that
the output gap numbers are pretty conservative. Unemployment in Greece is over
25%, and over half of all young people are unemployed.

2009

2010

2011

2012

2013

2014

Underlying
primary balance

(% of GDP)

-12.1

-6.0

-0.7

2.9

6.7

7.6

Output gap (%)

4.3

0.2

-7.1

-11.6

-14.2

-12.7

GDP growth (%)

-4.4

-5.3

-8.9

-6.6

-4.0

0.8

2009 was the peak underlying primary deficit, and it was huge,
representing the actions of a truly profligate government. However what
followed was complete cold turkey: within two years the underlying primary
balance was close to zero. A pretty conservative estimate for the impact of
fiscal consolidation would reduce GDP by 1% for each 1% of GDP reduction in the
primary balance. In those terms, all of the current output gap in Greece can be
explained by austerity.

As I have always said, some period involving a negative output
gap was inevitable because Greece had to regain the competitiveness it lost as
a result of the previous boom fuelled by fiscal profligacy. But slow gradual
adjustment is more efficient than cold turkey. Paul Krugman explains one reason for this: resistance to
nominal wage cuts. But there is another which is even more conventional. If we
have a Phillips curve where inflation expectations are endogenous (either
through rational or adaptive expectations) rather than anchored to some
inflation target (as Paul implicitly assumes), then competitiveness adjustment
can be achieved with a much lower cost in terms of the cumulated output gap if it is done slowly. (I gave an example here, then reacting to the idea that Latvia’s
cold turkey adjustment had been a success.)

There are only two serious barriers to this more efficient
adjustment path. The first is the willingness of some outside body to provide
the loans to fund the gradual reduction in the government’s deficit. The second
is getting those outside bodies to recognise this basic macro: austerity hits
output, and gradual adjustment is better. I think the second turned out to be
the crucial problem with Greece: as has been extensively documented, the Troika were hopelessly optimistic
about the impact cold turkey would have.

So it is as clear as it can be that the current dire position
of the Greek economy is the result of a huge mistake by the Troika. The size of
the collapse in the Greek economy is similar to the fall in Irish output during the
Great Irish Famine of 1845-53, and while the suffering in the latter is
obviously of a different order, the attitude of some in the Eurozone is as misconceived as most English politicians during the famine. Of that event they say 'God sent the blight but the English made the
famine'. In the future the Greeks may justly say ‘our politicians caused the
deficit but the Troika made the depression’.

Sunday, 22 February 2015

If Quantitative Easing (QE), why not helicopter money? We know
helicopter money is much more effective at stimulating demand. Helicopter money
is a form of what economists call money financed fiscal stimulus (MFFS). In
their current formulation independent central banks (ICB) rule out MFFS,
because the institution that can do the stimulus (the government) is not
allowed to cooperate on this with the institution that creates money (the ICB).
In a world where governments - through ignorance or design - obsess about
deficits when they should not, it turns out that MFFS or helicopter money is
all we have left to prevent large negative demand shocks leading to deep and
prolonged recessions. So why is it taboo?

One reason why it is taboo among central banks is that they
want an asset that they can later sell when the economy recovers. QE gives them
that asset, but helicopter money does not. The nightmare (as ever with ICBs) is
not the current position of deficient demand, but a potential future of excess
inflation that they are unable to control.

Here it is perhaps easiest to talk about monetary policy as
putting money into the system when inflation is too low or taking it out when
inflation is too high. QE creates money when interest rates are at their Zero
Lower Bound (ZLB), but that money can be taken out of the system later if need
be by selling the assets that QE buys. Helicopter money also puts money into
the system at the ZLB, in a much more effective way than QE, but it cannot be
put into reverse by central banks alone. The central bank cannot demand we pay helicopter
money back. [4]

If the government cooperates, this is no problem. The
government just ‘recapitalises’ the central bank, by either raising taxes or
selling more of its own debt. Economists call this ‘fiscal backing’ for the
central bank. In either case, the government is taking money out of the system
on the central bank’s behalf. So the nightmare that makes helicopter money
taboo is that the government refuses to do this. [1]

What kind of government would this be? Inflation is rising, and
the institution tasked with bringing it back under control makes a request that
can be satisfied fairly painlessly by the government issuing some more debt. A
government that refuses to do this is saying very publicly that it no longer
cares about high inflation: it prefers an environment of low interest rates and
high inflation and it is prepared to cripple its central bank to achieve this.

Now imagine a government with these preferences, and now put it
in a world where the ICB does not need recapitalising and is selling assets and
raising interest rates to do its job. Are we really meant to believe that such
a government would ignore its preferences and let the central bank get on with
it? Of course it would not - it would take away the central bank’s independence
by forcing it to stop raising interest rates.

In other words, a government that would refuse to recapitalise
an ICB is also a government that would have no hesitation in ending central
bank independence. Holding assets is no protection for an ICB against this
government of its nightmares. [2]

The reason we have independent central banks is not to stop us
becoming like Zimbabwe. It is to stop governments taking small risks with
inflation for short term political gain. Like the occasion I was told that the
Chancellor (at the time) knew full well that interest rates needed to rise now
to reduce inflation, but there was no way that would happen until after the
party conference. But this kind of government is not the kind that would
deliberately sabotage its own central bank by refusing a request for
recapitalisation.

Tony Yates writes of helicopter money: “Once government
gets a taste for it, how could it resist not helping itself to more?” This is a
statement about a government of nightmares that goes on a spending spree using
money created by the central bank, and not about real governments in advanced
economies. The idea that a perfectly sober government becomes a drunkard the
moment it sees its central bank undertaking helicopter money is absurd. If ever
we are unlucky enough to have a government that is a drunkard, an ICB with some
assets to sell will not be enough to stop it raising inflation.

So this nightmare that makes helicopter money taboo is as
unrealistic as most nightmares. The really strange thing is that ICBs have
already had to confront this nightmare. It is more than possible that when central banks
sell back their QE assets, they will make a loss, and so will be faced with
exactly the same problem as with helicopter money. [3] A central banker knows
better than not to worry about something because it might not happen. So the
nightmare has already been faced down. It therefore seems doubly strange that
the taboo about helicopter money remains.

[1] It is sometimes suggested that if the central bank runs out
of assets, it can create its own, by issuing central bank debt. This would be
effective if the nightmare government was unlikely to last, and a new
government would later emerge that would recapitalise the bank. However it
seems problematic as a solution for a permanently uncooperative government
where inflation is too high, because the only way the central bank can pay the
interest of the assets it issues is by creating more money. Corsetti and Dedola treat reserves as an
alternative to debt issued by governments, but here the idea seems to be to rule out default as an option.

[2] An independent judiciary could protect an ICB. However it
would be equally possible to write into law the duty of a government to ensure
an ICB can do its job.

[3] The Bank of England obtained an almost complete indemnity from
the government for QE losses, but other central banks have not (see Willem
Buiter here).

[4] The central bank could just loan the helicopter money. But in practice this amounts to the same thing: a government that will not back its central bank will tell people not to repay the loan.

Saturday, 21 February 2015

In reading this, which I will come back to, I thought
something short and simple was required

In 2010 periphery Eurozone countries, including Greece, faced
two problems: government deficits were too high, and as a result their
economies had become uncompetitive. (Excessive deficits - public or
subsequently socialised private - had allowed the economy to run too hot which
pushed up inflation leading to a loss of competitiveness.)

The deficits needed to be reduced. Under flexible exchange
rates this could have been done with relatively little cost in terms of
unemployment because competitiveness could have adjusted to its appropriate
level immediately via a nominal depreciation. The demand lost from lower public
spending could be compensated for by more competitive exports. In a monetary
union, this cannot happen, so a period of
unemployment is inevitable to restore competitiveness.

The key macroeconomic question is how quick adjustment should
be. Should competitiveness be restored quickly or slowly. Macroeconomics has a pretty
clear answer which comes from the Phillips curve (of whatever variety) -
slow is much more efficient. So it makes sense for some institution like the
IMF to provide loans to the government to allow it to eliminate deficits
gradually. There are lots of political and social reasons to make adjustment
gradual as well, but this is just about the macro.

Those are general principles. When it came to Greece, the
Eurozone made three key mistakes.

1)Too much austerity too quickly, violating the logic of
the previous paragraph. Sharp austerity can almost appear self-defeating in
deficit reduction terms, as it plunges the economy into severe depression,
making adjustment of any kind more difficult. The Troika has to take direct
responsibility for this mistake.

2)There was only partial (and delayed) default on Greek
government debt (see below). This was clearly not in Greece’s interest, but it
had benefits to other Eurozone countries.

3)Adjustment was required in an environment of Eurozone
recession and deflation, caused by needless fiscal austerity in the
non-periphery countries. Restoring competitiveness is much more difficult if
the countries you are adjusting with respect to have very low/zero inflation
(because people resist nominal wage cuts).

That is the past, but it has direct implications for today. (2)
means that the Troika were demanding Greece ran large primary surpluses in the
coming years to pay back the remaining debt and adjustment loans. This makes
correcting the error in (1) much more difficult, because it implies yet more
austerity. In terms of macroeconomics it is a clear mistake. (If Greece could eliminate its
negative output gap, it would be running a primary surplus of over 7% according
to the OECD, which would be enough for everyone.)

Now back to this Vox piece. It displays so much that is
wrong with macro arguments coming out of the Eurozone at the moment. Examples:

a.“For an economy in the dismal Greek situation, it
essentially made no difference that it remained a member of the Eurozone ..”
This ignores the basic macro in the second paragraph above. This denial of the
importance of wage and price rigidities, which leads to the key cost of being
part of a monetary union, has typified the Eurozone project from the start.

b.“Since in all these cases painful adjustment was
inevitable and costly, one should take the combination of the rescue packages
and adjustment programmes as what they really are – a device helping to avoid a
sudden fiscal and current account adjustment with even larger immediate pain.”
It is of course true that with access to markets cut off, adjustment without
any support from the IMF or elsewhere would in macro terms have been much more
immediate and painful. But the implication is that the speed of adjustment
matters, and in particular that it can still be too fast. The article makes no
attempt to address this central issue. The message that comes across to Greece
is that you should be lucky you got something.

c.“During the past five years Greece indeed underwent
serious reforms and fiscal consolidation. Progress has been remarkable …” What
is remarkable is the extent of the collapse in the Greek economy. Some kind of
recession was inevitable, but not a complete collapse in GDP, where over half
of young people are unemployed. The article tries to suggest that this is just
par for the course, rather than a function of the amount of austerity imposed.

d.“A debt relief of public creditors could not
substantially improve the comfortable state of the Greek government, let alone
be justified easily vis-à-vis its lenders.” This is disingenuous. It is true
that the effective interest rate on Greek debt is relatively low compared to
other Eurozone countries, but nevertheless the lenders are demanding Greece run
significant primary surpluses now, and
they need not make this demand.

I could go on and on, but this is meant to be short. To sum up,
the problems displayed by this article amount to a neglect of the importance of
wage and price rigidities, and the impact that fiscal austerity can have on
demand leading to a needless waste of resources. In other words, a denial of
basic Keynesian ideas.

Thursday, 19 February 2015

My first and most important point: pretty well every economist
I have read who has expressed an opinion on the matter recognises that a deal
which gives Greece at least some of what it wants is both desirable and
feasible. Yes, there is some disagreement about how bad a breakdown would be
for both sides, but little doubt that both sides would be better off with an
agreement that significantly reduces the degree of austerity imposed on Greece.
As these negotiations are essentially about economic issues and consequences,
that relative unanimity is worthy of an unprecedented intervention from the US
President. (Just in case you think that sounds too complacent, in the previous
link Ashoka Mody does make it clear the mistakes that some individual
economists and economic institutions made getting to this point.)

The second argument I wanted to make was how this example shows
the importance of knowing economic history. Defaults are not day to day events,
particularly if your focus is on advanced economies, so it is important to know
about how these events have gone before, and in particular how debt forgiveness
in the
past has had positive impacts. This includes Germany’s own history. There seems to be a growing
recognition that - at least in some places - economics teaching at both degree
and post-graduate levels has involved too little economic history.

Some have used events like the financial crisis to call for a
complete overhaul of how economics is taught. Heterodox economists want much
more pluralism, and many other social scientists want economists to be much
more familiar with what they know and do. I have some sympathy with both views,
but - as an economist would say - only at the margin. The reason is very
simple: to go even half way towards what these heterodox economists and social
scientists want would involve throwing out much that is even more valuable.

That is my third point. What has it got to do with Greece? To
be able to say intelligent stuff about what is going on at the moment (which
you would hope an economics education would enable you to do), you need to know
quite a lot of economic theory. A lot of macro of course, but quite a bit of
finance, and also at least some game theory. (Although those who know their game theory should
realise that at the moment the last thing on the mind of Yanis Varoufakis is
being academically accurate when speaking to particular audiences!) And if you
want to get into all those ‘reforms’ imposed by the Troika, you need a lot of
micro.

One of the comments on an earlier post of mine said that economists should try
and be less like doctors, and more like scholars. I completely disagree. For
all our imperfections, economists know a lot of useful stuff. If the last six
years has taught me anything, it is how wrong things can go when basic
economics is ignored. Those with economic problems to solve know this most of
the time (even if advice is often ignored), which is why
economics is essentially a vocational subject, not a liberal arts subject.

Of course we are not as good as doctors, and make more
mistakes, although sometimes we get blamed for things that probably would have happened anyway even if we had got
it right. I rather liked this study entitled ‘The Superiority of
Economists’. It ends as follows:

“Thus, the very real success of economists in establishing
their professional dominion also inevitably throws them into the rough and
tumble of democratic politics and into a hazardous intimacy with economic,
political, and administrative power. It takes a lot of self-confidence to put
forward decisive expert claims in that context. That confidence is perhaps the
greatest achievement of the economics profession—but it is also its most
vulnerable trait, its Achilles’ heel.”

When I read this, I think of Greek finance minister Yanis
Varoufakis - academic economist, and former economics blogger - and hope on
this occasion the confidence is retained, and that his Achilles’ heel is just a
myth.

Wednesday, 18 February 2015

I noted in my last post that without fiscal austerity the US, UK
and Eurozone could currently be at output levels that are above current
estimates of potential or natural output. (For the US a chart is here.) In other words the output gap would be
positive rather than negative. One response to that is to say without any
fiscal austerity monetary policy would have raised rates. But are these
estimates of potential output really independent of the path of actual output?

In a stylised view of macroeconomics the two are independent.
Productive potential calculates how much you could produce if both labour and
capital was fully employed using technology that itself is independent of
current and past levels of output. You can say the same thing in a more kosher
way by talking about natural output involving individuals working the amount
they wish given real wages that reflect market clearing etc.

We know that stylised view is wrong for a variety of reasons.
Labour that has been unemployed may become deskilled. Firms that are forced to
cut back on investment in a recession may take time to rebuild their productive
capacity. However there may be other ways it is wrong for reasons that are much
more difficult to quantity. In particular, if investment falls in a recession,
new technology that has to be embodied in new machines may fail to emerge, so
the rate of technological progress may appear to decline.

These processes may not matter too much in normal (mild and
short lived) booms and busts. However following a large recession they may
become more important. As many have noted (e.g. Larry Ball here),
estimates of the growth rate of productive potential made by organisations like
the OECD and IMF have been revised down substantially since the Great
Recession. The bigger the recession, the larger the fall in potential. As I
noted here, to rationalise this as a gradual supply
side reduction in the rate of technical progress (i.e. to avoid assuming
technological regress), these organisations have had to also revise their view
of pre-recession output gaps, to give what are frankly ludicrous numbers. It
seems much more probable that estimates of productive potential are strongly
influenced by actual levels of output.

If true, this is in one sense very optimistic. The process
could be reversible. We could expand the economy by much more than most
estimates of the output gap suggest, and estimates of productive potential
would to some extent rise too. As I have said many times, given this
possibility (and the huge costs of underestimating what potential is) we really
should explore it by keeping policy as expansionary as possible until movements
in inflation clearly tell us we have gone as far as we can. But this raises
another puzzle. If we have the capacity to produce much more, why is demand so
weak, when interest rates remain at the Zero Lower Bound (ZLB)? [1]

It is possible to construct sophisticated models of multiple
equilibria where beliefs (animal spirits if you like) can shift us between
equilibria. Roger
Farmer is the most notable example of someone who has explored this
possibility (see also David Andolfatto recently). Here I just want to
make a simple observation about why we should take such possibilities
seriously. The largest component of aggregate demand is consumption, and
consumption depends on expected income, which can depend itself on actual
output, and therefore on aggregate demand. The macroeconomy is therefore set up
to allow self-fulfilling multiple equilibria.

That possibility is plausibly bounded on the up side. Goods
have to be produced with capital and labour, and at some point workers at least
will start demanding higher wages to work longer, generating inflation, which
monetary policy reacts to by reducing demand. But the mechanisms that stop
self-fulfilling beliefs on the down side are more problematic. Monetary policy
finds it difficult to stimulate demand if interest rates hit the ZLB,
particularly in a world of inflation targets. At the ZLB continuously falling inflation
would become a liability (pushing up real interest rates), but thankfully
inflation may become very sticky near zero. The unemployed may drift out of the
labour force, or may become self-employed and produce much less, or real wages may fall such
that firms start adopting more labour intensive
techniques. For all these reasons, deficient demand may become persistent, to
some extent disguised and not obviously self-correcting.

Just think about what has happened in the years following the
Great Recession. Central banks and governments have steadily revised down their
views of what the long run level of output is. It is hardly surprising in these
circumstances, and with real wages stagnant or falling, that consumers would
also revise down estimates of their long run income, and adjust consumption
accordingly. In that way, demand appears to match a pessimistic view about long
run supply.

You should not ask how sure I am about such stories, but how
certain you are that they are wrong. If you are not certain, then the moral is
the same: after a severe recession which appears to result in a loss of
capacity, you use policy to explore the boundaries of just how much capacity
has really been lost, and run the risk that inflation may rise as you do so.
You do not sit back, tell yourself that below target inflation is probably
temporary, and do nothing. And, of course, you do not plan for more fiscal
austerity.

[1] Some central banks, most recently the Bank of England,
appear to be revising what they think the actual lower bound is. According to Britmouse, that means I should no longer talk
about either the ZLB or fiscal policy. Or as the skipper of the Titanic might
have said, that iceberg really shouldn’t have been there.

Sunday, 15 February 2015

In my Vox piece, I did a simple exercise to show how
important fiscal austerity has been in the US, UK and Eurozone. If government
consumption and investment had grown by 2% from 2010 onwards, and assuming a
multiplier of 1.5, GDP could be around 4% higher in all three ‘countries’. [1]

It cannot be emphasised enough what a huge waste of resources
this represents. If 1% growth was lost each year, then by 2013 that gives a cumulative loss of 10%
of GDP. That approximation works well for the US. It also roughly fits with Eurozone
estimates based on simulations of the NIGEM and QUEST models described here, but the Rannenberg et al study that I
have discussed generates cumulative GDP losses up
to twice as large. The UK is different from the US because austerity was
concentrated in the early years. Using the same methodology (i.e. a multiplier
of 1.5) you get a cumulated loss of around 14% of GDP.

For the UK I’ve often quoted a smaller figure of a 5% loss,
but based on an analysis which I have always been careful to describe
as conservative. It takes OBR estimates of the impact of austerity, which uses
lower multipliers (although it does include the impact of higher taxes, which I
ignore), and then assumes that all this lost GDP was recouped in 2013. Both
differences are equally important in going from 14% to 5%.

Why, for the UK, do I tend to quote the conservative estimate?
Four reasons. First, the government is fond of using OBR analysis when it
suits them, because their work has some authority. Second, the OBR analysis is
more detailed and comprehensive, and it implicitly allows for some monetary
policy offset, which may be reasonable given how high inflation was in 2011. (I
discuss this issue in much more detail here.) Third, I thought there was some poetic
justice in assuming that all of the GDP growth in 2013 was simply a bounce back
from earlier austerity, given that many people argue that 2013 growth
vindicated this policy. [2] Fourth, losing 5% of GDP is bad enough, so there
seemed no gain in using a higher figure, particularly when most of mediamacro
act as if the number is zero. But if you asked me what my best guess is, it is nearer 14% than 5%. [3]

As I show in the Vox piece, if US GDP was 4% higher in 2013 it
would be above the CBO’s current estimate of potential. The same is true for
OECD estimates of potential for the UK and the Eurozone. But all three
estimates assume that ‘trend’ or ‘potential’ GDP, or whatever you want to call
it, has slowed substantially following the Great Recession. In a subsequent
post I want to consider how reasonable it is to assume potential GDP is
independent of actual GDP, and why even my 10% (14% for the UK) figure could
be an underestimate.

Whether it is 5% of GDP, or 10%, or more, it is numbers like
this that I had in mind when I wrote these twoposts. They illustrate all too clearly the
asymmetric risks that I talked about there. If these numbers are right, but monetary
policy makers are nevertheless broadly content with their performance over the
last five years, they either have a completely distorted view of the costs of
inflation [4], or they have become fooled by a belief in the divine
coincidence: that they only need to look at inflation to judge performance.
(They could believe that they did not have the tools for the job, or that they
had the wrong target, but if that is what they thought that is what they should
have said.)

Going from the past to the present, Paul Krugman recently talked about the difference between insiders
and outsiders on policy. This also reflects my own experience in the UK. How do
we outsiders change this? I think the best place to start is by getting the
insiders to think about the costs of fiscal austerity. Once you do that, you
realise how large the recent failure of macro policy (but not macro theory) has
been, and therefore how important it is not to carry on making the same mistake.

[1] I write could, because any extra demand growth might - or
might not - have been offset by a tighter monetary policy. If it had been
offset, in this counterfactual world I would then be writing posts about the
foolishness of monetary policy.

[2] We would then have a perfect example of my ‘closing a part
of the economy down to boost future growth’ repost, which I used when people
wanted to describe 2013 UK growth as vindicating austerity. Paul Krugman prefers being hit by a baseball bat.

[3] So rather than my conservative estimate that austerity lost
every adult and child in the UK £1500, my best guess is nearer £4,000. (That is
£10,000 per average UK household.) The equivalent number for the US (10% of GDP
per capita) is just over $5,000, and for the Eurozone E3,000.

[4] A weak recovery probably shaved the odd percentage point
off inflation between 2011 and 2014, but if you ask most people how much they
would have been prepared to pay for this, I doubt if the answer would be in the thousands of
dollars, euros or pounds.

Saturday, 14 February 2015

This may seem a little
introspective, but there are some general points here about how economists deal
with the political implications of what they say.

I guess it is inevitable that as the UK election gets closer
more comments on this blog accuse me of being partisan and writing propaganda.
Let me start by saying what I think a partisan economist would do, and then
contrast that with what I try to do. [1]

Suppose a government does some economic related things well and
some things badly. A partisan opponent of the government (in a party political
sense) would focus on the bad things, and hardly mention the good things. They
would do the opposite for the opposition. I can think of one or two UK academic
economists who appear partisan in this sense, on both sides (pro or
anti-government), but they are very much the minority. Among the US
macroeconomists I know the same is true.

Part of the motivation for writing this blog in the first place
was a belief that the UK, along with the US and Eurozone, where making a fundamental mistake in turning to fiscal
austerity in 2010. It happens to be the case that this move is associated with
the political right, and it is inevitable that I would speculate on the reasons
for that. However the IFS has recently reminded us that Labour’s plans for
fiscal policy from 2010 were not so very different from what the Coalition
actually enacted. If Labour had remained in power and if (a big if) they had
stuck to their plans I would be writing much the same critical stuff about the
Labour government. (See this post on the European left, for example.) In my
NIER piece on the Coalition government’s record, I
praise two out of their three major innovations: it’s just unfortunate that
their third (fiscal austerity in 2010) is a mistake which dwarfs the other
two.

When I first started the blog at the end of 2011, I always knew
I would occasionally stray beyond macroeconomics. I have always had an interest
in poverty and inequality, but my first post
on that was hardly political - indeed it started off praising the UK Prime
Minister. At the end of March 2013 that changed. I wrote “Surely it should now
be clear that this is a government with at least as strong an anti-state,anti-poor
ideology as Mrs Thatcher, but with rather less honesty about what it is doing.”
The first ‘anti-state’ claim came from a realisation by that stage that the
drive for austerity was about more than reducing deficits. The second
‘anti-poor’ claim was justified in two following posts: the first documented work by the IFS showing how
government policies would lead to a steady increase in poverty, and that and a second talked about how sections of the press
went out of their way to denigrate welfare recipients, and how some (not all)
politicians went along with this. [2]

Is this partisan propaganda? I certainly think it would be good
to reduce both poverty and the incomes of the top 1%: the latter view can come
from understanding that recent growth represents a huge market distortion, which
economists naturally abhor. I also believe in treating those unfortunate enough
to be claiming benefit with respect, so what I write follows naturally from
those positions. As the chronology makes clear, I did not choose to write about
poverty because it allowed me to be negative about the government, which is
what a partisan would do. Another issue I feel very strongly about is climate
change, and again I cannot help it if the current government contains many who deny the proposition and
acts with - to put it mildly - some ambivalence towards the problem.

So this blog is not partisan. However it is also not
‘balanced’, in the sense of framing everything in ‘shape of the earth views
differ’ style, or avoiding saying the obvious because
it has political implications, as in this
classic BBC headline. If the logic of a position or argument is that one
political party has it right and another wrong, why avoid saying this? Nor will
I avoid expressing an opinion on voting behaviour: it seems abundantly clear to me that a future Labour government
would produce outcomes that are closer to the views expressed in this blog than
a future Conservative government, and that those on the left who argue that
‘they are both the same’ are seriously misguided. This is issue based
politics, and we need more of it.

So I do not worry too much about accusations of being partisan or too
political, but as ever I'm open to criticism that I'm failing in my objectives. I do worry more about something related, however, but not for the reason
you might think. In May 2013 I wrote something I had not imagined I would do
when I started the blog, which was a post essentially just about politics. It
compared UKIP and the Tea Party, in part because the dominant narrative seemed
to be that the rise of UKIP represented the consequences of the Conservatives
abandoning right wing views, which apart from certain ‘social’ issues seemed
simply wrong and analogous to arguing that the Tea party had arisen because the
Republicans had moved to the left! I have subsequently written a few other
‘political’ posts in this sense. In each case I try to write them as any good
social scientist should, which is trying to explain political developments,
rather than to give an evaluation of whether they are good or bad given my own
views. This can be difficult, and you have to choose your language with
particular care, as I note in this post. But my main worry when I write these
posts is that I will be displaying my ignorance of political science.

So what do you do if you want to read this blog for the
macroeconomics, but do not like some of the political implications that I draw? There
are hundreds of reasons to vote for a particular political party, and I would
hope there are many Conservative voters out there who nevertheless worry that
this government’s macroeconomic policy is misguided, and who are also concerned
about some other directions of travel. I wrote this post for those Conservative voters, and I want them to keep reading.

[1] Propaganda is information, especially of a biased or misleading nature,
used to promote a political cause or point of view. I have never written
anything that I know to be biased or misleading.

[2] Here is a more recent IFS assessment of the
impact of past policies. At about the same time Margaret Thatcher died, and I
wrote this short evaluation of her macroeconomic
record, which I do not think anyone can read as partisan.

Friday, 13 February 2015

A few people have asked what my reaction is to this
speech. I normally try and avoid listening to political speeches,
because I find it difficult to put my critical faculties to one side in doing
so - and on nearly every occasion you have to do so. To give just one example
(which applies to many Labour speeches as well as this one), it is odd to
criticise the policy of fiscal austerity, and at the same time complain that
the government has failed to meet its own 2010 fiscal target. It would be more
logical to praise the government for
abandoning its 2010 target. But politicians cannot resist criticising a missed
target.

But putting that kind of thing to one side, it was of course
really refreshing to hear a mainstream UK politician criticising the policy of
austerity. In reality what Sturgeon was proposing was still deficit and debt
reduction, but just not at the pace currently proposed by Labour. [Postscript - see Resolution Foundation for details.] (As I noted
in this post, there is a lot of space between Labour’s
plans and the policy of keeping the debt to GDP ratio constant.) Of course this
is in practice very similar to the ‘too far, too fast’ approach initially
adopted by Labour after 2010. The big difference here is the rhetoric. Whether
the current contrast between Labour and the SNP on austerity points to Labour’s
conversion to the dark side, their cowardice, or the fact that Sturgeon answers
to a Scottish rather than English media I leave to your discretion.

Of course this is the same person who, with Alex Salmond, was
only six months ago proposing a policy that would have put the people of
Scotland in a far worse fiscal position than they currently are, an argument that has been reinforced so
dramatically by the falling oil price. You could say that it is a little
hypocritical to argue against UK austerity on the one hand, and be prepared to
impose much greater austerity on your own people with the other.

However let me finish on a more positive note. I read a blog post recently that suggested this was an
election Labour would be better off losing. The argument was that a Labour
government would still be forced to impose austerity, and that it would as a
result lose support to UKIP in the North. A Labour government dependent on SNP
support would be abandoned by the SNP at the moment of greatest political
advantage to the SNP and disadvantage to Labour.

That is possible. However if we assume that the oil price stays
low there is no way a rational SNP would want to go for independence again
within the next five years. It might be much more to its long term advantage to
appear to be representing Scotland in a responsible way as part of a pact with
Labour. So what Sturgeon’s speech may represent is a setting out of terms, and
on this basis there is plenty of scope for agreement on the fiscal side at
least. And if that agreement leads to less immediate austerity, I for one will
be happy.

Thursday, 12 February 2015

My London Review of Books article is now available online. It is much
longer than the normal blog post, so it allows me to put together a lot of
points in one place. It tells the history of the macroeconomic policy response
to the Great Recession. How in 2009 policy responded in the right way (in terms
of direction if not magnitudes), but how in 2010 it all went very wrong with
the move to austerity. It is told from a UK perspective, but similar stories
can be told for the US and Eurozone. It says why austerity was a mistake, and
how both politicians and most of the media have tried to avoid this conclusion.

Besides length, the other main difference is the effort I have
made to write clearly for non-economists. (Whether I have succeeded you can
judge, but to the extent I have the editorial team at LRB deserve a lot of the
credit.) Of course I would like to do this all the time in my posts (unless I
signal otherwise at the beginning), but I’m acutely aware that I often fail.
Mostly it reflects lack of time. I try to always do one read through thinking
how would a non-economist interpret this, but as anyone who reads through their
own work knows, if it is something you have just written it is quite difficult
to be objective. My ‘post the next day’ rule helps here, but I do not always stick to
that rule! (Occasionally jargon can be descriptive: ‘automatic stabiliser’ and ‘lender
of last resort’ spring to mind from the article.)

Writing a piece like this also makes it clear how difficult
macroeconomics in particular is. Everything is, at least potentially,
connected. To tell the story of fiscal austerity you do not only need to talk
about the impact of spending cuts on demand and output. You also need to talk
about monetary policy, and therefore Quantitative Easing. Not just to discuss
potential monetary policy offset, but also why the Eurozone is different, which
means talking about the relationship between short term interest rates and
interest rates on government debt. I do this all the time when writing academic
papers of course, but for a non-academic audience the rules for what you
include and what you leave out have to be different.

The hardest thing is to switch off the academic part of me
which is saying: you really should cover that, or that is a very imprecise way
of making that point. For example in the LRB article I did not go into a
discussion of whether, because UK inflation was high in 2011, interest rates
might have increased if there had not been austerity. That discussion you can
find in detail in my NIER article, but I decided including it in
the LRB discussion was both unnecessary and distracting. However I did mention
helicopter money (by request), because a natural question for a non-economist
to ask is why the central bank is creating money to buy financial assets rather
than giving it directly to people? (Actually that is a pretty good question for
an economist to ask as well!) What I wrote was that financial assets can be
sold again when the recovery is complete if the bank judges that there is too
much money in the economy, but that of course begs the question of whether
there are other means of reversing helicopter money. You just have to stop
somewhere, and leave important issues out.

The other thing that struck me writing both the LRB and NIER
articles was how little depends on the benefits of hindsight. When I did my analysis of fiscal policy under Labour, the
major criticisms did reflect subsequent events: in particular that the fiscal
rules should have aimed for a gradually falling debt to GDP ratio. With the
Coalition, the key mistake was obvious at the time. What has come with
hindsight are in a sense details, albeit important ones: exactly why the
Eurozone was special, the motivations behind the policy, and mediamacro.
However I think the more interesting comparison, from a UK perspective, is
between macroeconomic policy under the Coalition and the 1979 government under
Margaret Thatcher. That would be an article I would like to write sometime.